The first Federal Open Market Committee (FOMC) meeting of 2024 is behind us and markets no longer appear convinced that we will see an interest rate cut the next time the 12 members of the committee meet in March. About 34% of the market expects a rate cut at the next meeting, down from 73% just a month ago. In fact, I don’t expect the Federal Reserve to start cutting rates until the end of the second quarter, at the earliest.
Economic data suggests there is currently very little justification for a rate cut in March. Inflation was higher than expected in December, the job market remains tight and retail sales rose more than expected last month. Of course, much of this was driven by the holiday season, and the annual January gloom will almost certainly drive inflation and spending lower. However, this will likely be a short pause before a recovery later in the quarter. Overall, the economy is still hot and economic data is driving the FOMC’s monetary policy decisions.
Sticky core inflation will keep the Fed on its toes
Inflation in December surprised the market with an increase from 3.1% to 3.4%, while core inflation, the Fed’s preferred measure, increased by 0.3% month-on-month (MoM) and by 3.9% year-on-year (YoY). Our data reveals that inflationary pressures have come primarily from the services sector in recent months, although December also saw an increase in purchases of luxury goods.
In turn, services inflation has been exacerbated by tight labor markets. Despite some talk of easing working conditions, December’s unemployment rate remained extremely low at 3.7%. In recent weeks, initial unemployment claims have averaged just under 210,000, well below historical averages. In fact, we haven’t seen a single monthly decline in jobs since 2020.
At the same time, wage growth accelerated again, hitting a year-on-year rate of 6.5% in November, up from 5.7% in October, partly driven by pressure from unions. Rising wages, combined with credit spending and strengthening consumer confidence, fueled consumer spending. U.S. retail sales beat analysts’ expectations in December with an increase of 0.6% month-over-month and 5.6% year-over-year.
A more aggressive FOMC
In this economic context, the market seems to have misinterpreted the signals from Fed Chairman Jerome Powell. While the President has said that a discussion of rate cuts is “in the offing,” he has also been consistently clear that his primary focus remains the 2% inflation target, even at the expense of an economic slowdown. There is nothing in today’s meeting to suggest he has changed his mind.
Indeed, Powell’s rhetoric for much of 2023 has been more hawkish than the market gave him credit for, although we have seen his stance soften over the past couple of months. However, with core inflation almost double the Central Bank’s target, there is little reason to believe we will see a cut this quarter.
If anything, this year’s changing of the guard at the FOMC could lead to an even more aggressive stance. Only one of the four incoming members (San Francisco Fed President Mary Daly) has publicly called for a discussion on rate cuts. Richmond Fed President Tom Barkin wants to see further declines in inflation, Atlanta’s Raphael Bostic sees cuts in the second half of the year and Cleveland’s Loretta Mester says market expectations are “a little ahead” of the Fed’s : a diplomatic euphemism if we ever heard one.
It will also be interesting to see whether the committee can maintain the same level of cohesion in its decisions in 2024. After all, this year’s monetary policy calls will likely be more contentious than what we saw in 2023. A more divided FOMC could also delay any interest rate cuts.
A delicate balance
After a difficult 2023, victory in the Fed’s battle against inflation is now within reach. However, with the economy overheating and an uncertain macroeconomic climate, it is more difficult to predict the path of inflation compared to last year. Several factors, including growing geopolitical unrest, could push inflation higher. However, the effects of monetary tightening also take time to manifest, so we may soon start to see an economic slowdown. Therefore, balancing its dual mandate will be no easy feat for the Fed this year.
While the economy remains strong and the threat of sticky inflation remains, the Fed will likely continue to take a cautious stance on interest rates until the murky backdrop becomes clearer. Even when core inflation eventually retreats toward the 2% target, we do not foresee the aggressive cutting cycle that many experts had predicted. Higher rates are here to stay and it is time for the market to accept this new paradigm.
Oliver Rust is the head of product at independent data aggregator Truflation.
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